Killing Flip was just the beginning

FORTUNE — There’s a certain allure to being a household name, so you almost can’t blame Cisco CEO John Chambers for trying to push his company into consumer markets. But that allure is ultimately superficial. Cisco’s core products are routers and networking equipment. Those businesses might be dull, but that’s where Cisco (CSCO) has thrived. On the consumer front, it has flopped.

Last week, Cisco announced that it would stop making the popular Flip camcorder. The company announced that it would focus more on its core businesses. The challenge there is that the networking-gear business is rapidly changing, with prices (and hence, margins) falling and new competitors entering the market.

Still, Cisco is the leader, owning as it does about two-thirds of the market for networking equipment. And with the economy recovering, big customers are finally making needed purchases they had been putting off for as long as they could. (One exception: cash-strapped governments.)

How uncertain is the market? Consider that 2010 saw revenues in Cisco’s sector grow by about 10%, while industry profits soared by 42%. At the same time, the sector’s market value fell by 23%, mainly thanks to Cisco’s limp stock. Cisco fell steadily throughout 2010, and has spent 2011 dropping even more sharply. It started the year at about $27. It closed Friday at just above $17.

Investors had been clamoring for the company to exit the consumer business. The Flip, in particular, suffered from thin margins and — though it was popular — a highly uncertain future as the built-in video functionality of smartphones kept improving. Why buy a Flip when the Apple (AAPL) iPhone 4’s video feature is just about as good? Cisco bought Flip-maker Pure Digital for $590 million in 2009 — a relatively small purchase for the highly acquisitive company but, to many investors, a hugely symbolic one.

(Many people have asked, given that the product is still selling, why Cisco didn’t sell off the Flip. One Forbes blogger decided shutting down the division was “a flashy and dramatic denouement” to appease critics of the company’s consumer strategy. It seems more likely that Cisco execs decided they couldn’t have recouped its purchase price on the open market, and simply flipping the switch on Flip was the least costly option. Or maybe Cisco just wants to keep the product’s technology for itself – it is, after all, still in the video business. The company did not respond to a request for comment.)

Cisco’s core business enjoys much better profit margins, but those margins could be narrowing. Competitors like Juniper Networks (JNPR) And Aruba Networks (ARUN) are putting pressure on prices. Cisco has thus far been able to resist lowering prices, but it’s not clear how long Chambers and co. can hold out. Meanwhile, other competitors, large and small, are entering the market. Even as Cisco takes on Hewlett-Packard (HPQ) in the server business, HP is investing big in networking equipment.

A snapshot view of the switching business makes things look great for Cisco. It has an 80% market share. Gross margins are in the 75-80% range. Sales grew by 12% in the fiscal year that ended last July.

But that’s deceptive. In the current year, sales growth has fallen to about 7%, and competitors are cutting prices, accepting margins of just 40 or 50%, or even less. That hardly makes switches a commodity business, but the trend is clear. That’s why Chambers last week called the switch business a “tough market” even though his company, for now, controls two-thirds of it.

In a note last week, Citigroup analyst John Slack wrote that, “Cisco needs to choose between protecting share or preserving margins. It simply can’t do both.” The reality might be less zero-sum than that, but it’s true that Cisco won’t be able to fend off competitors forever and keep its market share.

Killing off the Flip will help shore up company-wide margins, but Cisco will likely have to do more — the Flip represented just $325 million in revenue last year, or less than 1% of the company’s sales. The purchase was part of a larger strategy to get Cisco into the home video business, which as a whole has eaten into margins.

Chambers said future moves will be carried out with “surgical precision,” but he didn’t offer much in the way of specific plans. As it shut down Flip, the company also absorbed its ūmi videoconferencing business and its Eos media-server products into its business offerings, taking them off the consumer market where they had been languishing.

Newly hired Chief Operating Officer Gary Moore will head up Cisco’s new focus. The company last week identified five “priorities”: routing and switching; cloud computing and data centers; “architectures” (network design); and video.

The company’s Linksys home-networking products might, at a stretch, fit into “routing and switching,” and its Scientific Atlanta set-top box business fits into video. But with the folding of other consumer and video businesses into Cisco’s business-focused lines, both seem ripe for a sale, and analysts generally seem to agree those businesses are the ones that should be next to go from Cisco’s portfolio.

Chambers said last week that, “our consumer efforts will focus on how we help our enterprise and service provider customers optimize and expand their offerings for consumers, and help ensure the network’s ability to deliver on those offerings.” That’s just squishy enough to be almost meaningless — it could provide a basis for either keeping or getting rid of Cisco’s remaining consumer businesses. On balance, it seems likely that it will will cast off one or both of Linksys and Scientific Atlanta in the near future.